Why deficits don’t matter – for now

Before criticising debt was fashionable, George Washington got in on the act, famously stating, “There is no practice more dangerous than that of borrowing money”. Apparently Washington was right, if the recent worrying over the American twin deficits is anything to go by. Of course, this isn’t to say that economists weren’t worrying last year too.

The media pages in the past few months have been full of speculation over the state of the US dollar and growing levels of debt. But politically at least, deficits don’t seem to matter much. During the Great Depression, President Franklin Roosevelt’s Keynesian spending pushed the budget into the red at a time when foreign trade was down. Yet he just kept on winning elections.

Ronald Reagan is another case in point, having successfully served out two terms despite widespread controversy over his economic policies. George Bush’s more recent election victory merely continued the trend.

It’s worth noting that American governments tend to spend wisely when the executive branch is in constant conflict with the legislative. Indeed, Democrat Bill Clinton faced a hostile Congress and had major initiatives blocked, undoubtedly contributing to his achievement of a budget surplus. However in the last term of Congress, Republicans, who are traditionally fiscally conservative, have used their majority to pass spending bills with a minimum of fuss.
 
Economically however, deficits and debt do matter, although the extent to which they do and how they do is a matter of complex debate best reserved for those with PhDs tucked under their belts. But there are a few points that can be mentioned here. First, it should be noted that within the public debt, there are two kinds of debts: publicly held debt and intergovernmental debt.
 
Publicly held debt is debt which is held by foreign governments, financial institutions, and other members of the general public. Intergovernmental debt, which accounts for about 40 percent of total debt, is debt which mainly consists of loans from one government program to another - this is essentially debt that the government owes to itself, but is included in the public debt figure because of accounting practice. As you will see, this makes the gross figures in the following paragraph sound less threatening.

As things stand, the current account deficit is at nearly $700 billion, while the budget deficit hovers around 4 per cent of gross domestic product. Total US public debt now exceeds $7 trillion, amounting to approximately 60 per cent of GDP. This is less than some comparable economies in Europe, and many emerging economies.

When examining American debt and its implications, it is useful to pinpoint precisely where money is owed. Asian economies such as China and Taiwan supply much of America’s foreign debt, while the majority is owed domestically, meaning a significant portion is owed by Americans to Americans. Such a situation is vastly better than if the majority of public debt was owed to foreigners.
 
Because loans give the government the option to finance investment it would otherwise not have money for through tax revenues, when these projects turn out to be profitable the debt becomes worth the risk. Generally speaking, there is an acceptance that cyclical deficits (during a recession, such as the one experience by America during Bush’s first term) are healthy, whereas long-term structural deficits are unhealthy because they can be easily perpetuated.

The Cato Institute recently published a book by German reporter Olaf Gersemann titled Cowboy Capitalism: European Myths, American Reality. Gersemann “debunks” the idea that the American economy is somehow weaker than the European economies, finding that in America the growth of wealth has outpaced debt, with the average American family increasing its net worth by 50 per cent between 1989 and 2001.

So, a bald statement of the absolute size of public debt glosses over the fact that wealth and productivity have increased tremendously over the decades. Put simply, it would appear safe to say that a wealthier nation can sustain a greater level of debt than a poorer nation.

Hence, the problem should be seen not so much as large deficits or debt - as there are various intricacies in the accounting measures that can be used to skew the figures one way or another depending upon one’s political persuasion - but government spending, and therefore the size of a government’s programs itself.

From a historical perspective, the cause of the rise in public debt can be attributed to wars and recession. Political pressure has ensured various welfare expenditures such as social security and unemployment compensation have expanded sharply in terms of coverage and level of benefits.

Americans have a poor track record on savings, meaning high levels of foreign investment are what keep living standards moving upwards. The continued success of industrialised economies such as the US is more likely to reside in whether government policy fosters growth, boosts exports and improves productivity, than on - for instance - the standard currency of exchange remaining dollars instead of euros.

With increased economic output, debt becomes comparatively smaller, and therefore easier to pay off. In due course, the Bush administration would be wise to gently curb spending and cut taxes. Meanwhile, the push towards free trade must continue. Why? Because a growing economy, unlike a static one, can have its cake and eat it too.